DFA recently highlighted the rise of the bank of Mum and Dad. In The conversation, there is an article highlighting some of the potential risks, especially with formal bank guarantees.
Ask a parent how far they would go to support the financial aspirations of their children, and chances are they will say: “Yes, if I had the money I would be happy to act as a guarantor for my children to purchase a property.”
Australian capital city house prices rose by 7.9% in 2014, while the number of first home buyer commitments as a percentage of total owner occupied housing finance commitments is near record lows – 14.2% in January 2015, compared to 20.4% in December 2012.
Many family-assisted first-home purchases are not being counted in the first home buyer data collected by the Australian Bureau of Statistics, but it’s likely the growing cost of owning a home is encouraging an increasing number of parents to help out via a guarantee, interest-free loan, initial deposit or simply making a monetary gift to their children. This financial support can change an individual’s decision to buy or rent a house or unit. Parental support can also help first home buyers avoid mortgage insurance charges that can easily exceed A$15,000 for a family home in a desirable suburb.
The risk to parents
Consumer advocates cite “lots of cases” where guarantors have been faced with the prospect of losing their home.
Since 2004 Australian banks have offered specific “family pledge” or “family guarantee” loans, allowing parents to provide both equity support and income support. These products are driving growth in the sector, adding to the risk for parents.
In the current economic climate with rising unemployment and costs of living, parents need to understand the risks of acting as guarantor, and all the legal responsibilities that come with it. The guarantor has a legal responsibility to repay the loan (along with any fees, charges and interest) if the borrower defaults. If the guarantee is tied against assets such as the family home, guarantors may end up losing their home, particularly if the parents’ financial position or health conditions have changed over the years. Often the lenders can sue the guarantor if the loan obligations are not met by the debtor. If parents have concerns, it may be a good idea to contribute towards the deposit so that a guarantee is not required.
It is equally important for parents to be educated with regard to the purpose of the loan, amount of the guarantee, to know in detail if their children have stable incomes, and the kind of loan they are guaranteeing (such as lines of credit or overdraft which have no specific time to maturity).
The risk to the banking sector
Family-pledged loans can be categorised as non-conforming loans, an area where lenders seek to minimise the level of risk as much as possible. The Australian Prudential Regulatory Authority has outlined some guidelines for ADIs with regard to loans including a guarantor relationship (e.g. from a parent of the borrower) to cover shortfalls in minimum deposit requirements. APRA acknowledges these loans carry a high risk and ADIs should carefully assess the guarantor’s income, credit worthiness, enforceability of potential claims and the value of any collateral pledged by the guarantor. APRA also emphasises that as a risk management strategy a prudent ADI should establish portfolio limits within its risk appetite for such lending. Such limits can be stress tested.
Since the 1997 Wallis Inquiry, household leverage has almost doubled. This has been accompanied by a significant increase in house prices relative to income over the past decade. Australian home prices are 50% higher than usual relative to rents, and around 40% higher than usual when compared to incomes. The Bank of International Settlements has already warned that a price correction may be coming.
The Financial System Inquiry is seeking measures to ease the effects of the housing market on the economy along with ways that these measures can be implemented.
Inadequate bank supervision and poorly underwritten home mortgages led to the financial crisis. Easing credit constraints, delivering innovative products (along with fee generating activities) without considering the associated risks, and a lack of internal and external monitoring and supervision, can increase non-performing loans and threaten the financial system and its stability.
